Regulation 28 and the paradox of choice


Conlias Tafadzwa Mancuveni | Head | Implemented Portfolio Solutions | Hollard Investment | mail me |

In February 2022, Finance Minister Enoch Godongwana amended the maximum offshore investment limit for Regulation 28 retirement funds from 30% of assets to 45%. But data shows that most funds haven’t maximised their exposure to the new limit, begging the question: why?

Regulation 28 of the Pension Funds Act, governing this offshore limit, has been amended steadily since 2004, when it stood at 15% of fund assets, to Godongwana’s most recent high (that includes a 10% limit on African investments).

The current average global asset allocation

On the face of it, greater offshore choice is exciting, given that it broadens the investment opportunity set and allows for risk mitigation, particularly in relation to South Africa’s many economic challenges. Moreover, the size of South Africa’s equity market is less than 1% of the total global equity markets.

Whereas in the past this maximum offshore allowance has been quickly taken up by investment managers, that hasn’t been the case this time. While we anticipate that the new strategic and long-term optimal offshore exposure for the Association of Saving and Investment South Africa (ASISA) multi-asset high equity sector funds will be at about 35%, the current average global asset allocation is at an underweight 32%.

To be fair, 18% of investment managers are already in the 40%-plus range, and this is increasing. But most are large managers, and they’ve increased their allocation partly because they are probably playing the long-term game and partly because of their restricting large size in the South African market. Also, our equity market is shrinking both in number of listed stocks and volumes traded, making things relatively more difficult for large managers: JSE-listed companies have dwindled from more than 370 in mid-2018 to 294 in July 2023.

Offshore strategic asset allocations for the ASISA multi-asset high equity funds have been substantially increased by most managers to whom we have spoken. But tactically, the investment industry is taking a careful stance on developed markets equity, and the small increase we have seen past the previous 30% limit is more likely due to movement in the rand-US dollar exchange rate.

Historically, South African investment managers have emphasised valuations, and they’re not rushing into expensive developed equities.

Currently, there is way more value to be extracted in the local market: local equities are trading on a very cheap forward price-to-earnings multiple of 9x (compared to 17x for developed markets) and underpinned by strong one-year expected consensus earnings growth of 14% (compared to 7% for developed markets); the local long bond market is also offering enticing value, with a more predictable nominal long-term expected yield of 12% against inflation nudging at 5%; and the rand offers a 20% discount to the fair value range against the US dollar.

Conversely, if Regulation 28 funds use their Rand income to increase US dollar-denominated assets, they’re currently paying 20% above the currency’s fair value range.

So what now?

Is the new Regulation 28 limit a good thing? What does it mean for financial advisers and their clients, and retirement fund boards of trustees and their members? More choice means a wider range of potential return outcomes, but it also means more complex decisions, implementation and monitoring. More importantly, it requires deeper expertise to select, combine and monitor appropriate offshore partners and providers.

In contrast to the shrinking number of JSE-listed shares, South African funds (including Regulation 28) are growing strongly, with more than 1,700 rand-denominated funds, and counting, and more than 800 FSCA-approved foreign-denominated funds (90% of which are equity-related funds).

So where does one start, given all these options? How do financial advisers and retirement fund trustees prudently assist their clients and members to navigate the new Regulation 28 changes?

Our experience is that key decision-makers are grappling with the paradox of choice: on one end the breadth of options increases freedom and flexibility, but on the other, it’s more difficult and daunting to choose the high-quality and consistent winners, and blend them in their appropriate proportions.

The question arises as to whether or not South African single managers are sophisticated and equipped enough to handle offshore exposure. It’s worth noting that single managers globally struggle to outperform an index approach: only 10% to 20% in the past 10 years have done so, and less than 10% have done so for longer than 10 years. The results are slightly worse for South African managers over both periods. This makes manager selection a critical skill.

So then, what does an appropriate investment manager who can help financial advisers and trustees navigate this paradox of choice – South African or otherwise – look like?

Having a solid grasp of portfolio risk management

We believe that it’s most important for managers to have an investment philosophy, objectives and investment process that are all clearly defined.

The investment philosophy should articulate core investment beliefs and principles of how investment value is extracted and risk-managed, expected patterns of returns, inputs required, and evidence of repeatable outcomes.

Secondly, given that strategic asset allocation is the main driver of long-term returns, contributing 70-80% of the total return, the manager’s approach needs to be clearly defined and updated as market conditions change. Thirdly, tactical asset allocation and risk management are key in exploiting and managing short- to medium-term opportunities, as well as unintended and outsized risks.

Next, managers need to have a solid grasp of their portfolio risk management on a look-through basis: this allows an investment manager to understand exposure from various perspectives, be more responsive and agile, and continually reinvent themselves as they align portfolios with changing times.

Portfolio risk management can identify and de-risk outsized risk contributions from geographical and sector exposures.

For example, US equities make up around 60-70% of exposures in most developed markets’ equity funds and they, in turn, are typically overly exposed to the concentration risk of the technology sector. Good managers can also manage and reduce foreign currency volatility.

In conclusion

Good investment managers appreciate that investment is about the people doing it. Investment firms all have the models, tools and processes, but what they really need to build are sustainable businesses, where the investor, investing team and shareholders all win. They need to aspire to be great stewards and fiduciaries with the highest ethics, have a strong and enabling culture (along with a mechanism that rewards and sustains innovation) and be aligned to the interests of their clients.

Many studies have shown that an investment business can enhance and create sustainable value for investors through intentional and well-designed, diverse and multi-skilled teams.
Investing is a long game of making choices. At the end of the day, it’s about doing the right business with the right people. It’s about partnership.

For financial advisers and retirement funds looking to prudently exploit the changes to Regulation 28 and navigate the paradox of choice that it creates, the point of departure is always going to be choosing the appropriate investment manager(s) who will in turn make appropriate choices on their behalf.



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